Everyone on Wall Street is saying the same ridiculous thing about China

For about a week now, everyone on Wall Street has been saying the
same ridiculous thing about the Chinese economy — that with a
little communication, the volatility that the country is
experiencing (and spreading around the world) will end.

It sounds great, and it's true that a lot of things that can
happen in the market are about expectations that actors have or
have not set up beforehand.

China's volatility isn't one of them.

It's a systemic condition resulting from the shift in China's
economy from being one based on investment to one based on
consumer consumption. The only thing that will stop it is the
completion of that shift. That shift can only be completed —
roughly or smoothly — through action. Not through talk.

I'll explain why, but first let's figure out where this
"communication" issue was first brought up.

Davos, the most serious place in the world

I'm going to go ahead and blame this new "communication" meme on
the head of the International Monetary Fund, Christine Lagarde.
She's the one who started this whole thing at the World Economic
Forum in Davos, Switzerland, last week.

"There is a communication issue," Lagarde said
on a Bloomberg panel on China. On the same panel, Gary Cohn,
president of Goldman Sachs, echoed that sentiment, saying, "the
communication is really what’s important here."

Christine Lagarde and
company at the Bloomberg China panel in Davos.Reuters

Luckily, a Chinese official was there to acknowledge that, yes,
his country could do better communicating with the west.

"You’re right we should do a better job, and we are learning,"
Fang Xinhua, vice chairman of the China Securities Regulatory
Commission, said.

"I’m here today to communicate," he said, spurring chuckles from
the audience. "Our system isn’t structured in a way that’s able
to communicate seamlessly with the market."

But by golly they will try, seems to be Fang's point. In the
meantime, analysts all over Wall Street are picking up on
Lagarde's language. Take Societe Generale, for example, which on
Tuesday published a note saying:

There is a credibility issue on China's policies, especially the
FX policy. The uncertainty and lack of clarification from the
authorities regarding these policies is a key concern for the
markets, which consider the policy response to the economic
slowdown and market turmoil as insufficient.

Societe Generale

The Chinese government has been talking about policy responses
for months now. They've talked about sending capacity out of the
country through the "One Belt, One Road" regional infrastructure
program; they've talked about
creating measures for organized bankruptcies of indebted
state-owned enterprises; they've talked about keeping the
yuan as stable as possible.

None of that talk is settling anyone, though, because now it's
time to do.

I hate to say this, but 'confidence game'

And here's how we know it's time to do.

On Tuesday, we learned that in 2015, $1 trillion left China. That
was before anyone on Wall Street was talking about "communication
issues." It was before the volatility we're experiencing now.

It happened during a period in which the structural issues with
China's economy started to really hurt growth. It's when the
government cut interest rates and bank-reserve requirements and
made it easier for Chinese people to buy a car. It was when
everyone started to get worried.

It's also when, in response to bad economic data and resulting
from a natural slowdown in growth, China devalued the yuan in
August. Directly after that China had its worst outflows of 2015
—
$194 billion in September.

The yuan and Chinese outflows stabilized in October and November
while the currency was seeking entrance into the Special Drawing
Rights club — a special group of reserve currencies designated by
the IMF. After the yuan was accepted at the end of November,
it started to slide.

In December, the Chinese government burned $108 billion of its
reserves to keep the yuan from falling so fast. Not to keep it
from falling, but to keep it from falling too fast. That month,
China experienced $134.4 billion in outflows.

It seems Societe Generale
published this chart BEFORE the $1 trillion outflow number came
out.Societe
Generale

The government has been wrestling with the yuan ever since, and
it's a costly, reserve-depleting effort. China needs those
reserves to get through this reform period, so some officials
think that the government should just do one big devaluation and
then end it. That way, investors have a set value for the yuan
and know that it's not going to depreciate further. The opposite
of uncertainty is a guarantee. Wall Street loves guarantees.

The government, though, doesn't seem keen on that. That is likely
because, as long as the Chinese economy is slowing, the value of
the yuan will naturally erode.

No one knows how long this slowdown will continue, so no one
knows where the floor should be. They don't know where to put the
guarantee.

And how can a government communicate what it simply doesn't know?

What you're not going to do

What we do know is that China is tightening capital controls, and
telling any trader who will listen that if they have the gall to
short the yuan there will be consequences.

Here's what the government said about it in an editorial
published in state media outlet Xinhua.
It was signed by an alias known to be used by the government
(emphasis added):

As for those who want to bet on the "ultimate failure" of the
Chinese economy, they should look back at the past four decades,
which witnessed China's growth from an underdeveloped economy
into a global economic powerhouse through continuous reform and
opening up.

They should also take into consideration the fact that the
Chinese government has been constantly improving the country's
market regulatory system and legal system. As a result, reckless
speculations and vicious shorting will face higher
trading costs and possibly severe legal consequences.

George Soros is retired,
China.REUTERS/Nicky
Loh

China even
took a shot at legendary investor George Soros, who
said at Davos that China would most likely have a hard (but
survivable) landing.

Soros once shorted the British pound in a legendary squeeze, so I
imagine the Chinese were just concerned that the yuan's position
might entice him to get out of retirement.

This messaging has been backed up by action. Earlier this month
the Chinese government went
after yuan shorts in Hong Kong, buying the currency and
squeezing them to death in the process.

The question is, how long can China keep going to war like this?
Businesses can find ways around capital controls, and traders
aren't scared every minute of the day. The country needs to show
yuan holders that their currency is not going to keep
depreciating in value.

And that can only happen when the economy — the real economy —
shows signs that promised reforms are taking hold. That may
involve some super-indebted state-owned enterprises defaulting,
so that investors know that there's moral hazard, and that China
is starting to pick its way through the debt deluge that is its
corporate sector.

In short: China's problems aren't going to be solved by more
communication. They're going to be solved by the same things that
were going to solve them a year ago — a restructuring of the
country's overindebted, underproductive corporate sector, and a
reduction in overall overcapacity.

Action, not talk, is what will calm the volatility in China's
markets. And that action is incredibly difficult to undertake.